The focus on growth has impacted margins which is the reason of the poor stock performance.

The stock offers significant upside if margins recover and we think it will.

Company overview

Attendo offers elderly care in nursing homes and in home care (76% of sales) as well as care for people with disabilities (24% of revenue). The group is present in Sweden, Finland, Norway and Denmark. Attendo operates more than 700 units and employs about 24,000 people. The company has a market cap of SEK 8.8B (roughly $913M) and is listed on the Nasdaq Stockholm. The company operates under two kinds of contract models:

- Own operations (80% of sales): Attendo designs, builds and operates nursing homes even they do not own the properties (they enter into a 10/15-year lease agreement with a partnered construction company which owns the building)

- Outsourced facilities (20% of sales): Local authorities are responsible for the premises but outsource the operations to Attendo. The outsourcing contracts follow a tender process and last typically between two to five years.

Recent underperformance

After a strong run following its IPO in November 2015, the stock has started to underperform its peers (as well as the broader market) since mid-2017. This underperformance can be explained by the following reasons:

- Increasing regulatory burden in Finland following a large number of on-site inspections

However, before explicitly talking about these topics, we are going to highlight the strong fundamentals of the industry in which Attendo operates.

Sector overview

The sector is very attractive because it is a non-cyclical sector with a strong demand (driven by an ageing population and the development of chronic diseases such as Alzheimer) and a supply shortage (lack of investments). Furthermore, the low penetration rate of private operators combined with the ongoing outsourcing trend of municipalities should benefit private operators. The fragmented market is also an opportunity for the largest private operators.

Ageing population and development of chronic diseases

The demand for home care and nursing home should steadily increase over time. Indeed, the population aged 85+ is expected to grow at a >3% CAGR over the period 2017/2030 in Sweden and Finland, which are Attendo’s two main markets.

Furthermore, chronic diseases increase with an ageing population, which result in higher demand for care.

2) Supply is short

Most European countries face a shortage of beds/nursing homes because of past underinvestment. Indeed, the different European governments are financially constrained (public funding) and the number of elderly keeps increasing, requiring even further investments in the future.

The situation is similar in the Nordics. The proportion of Swedish municipalities reporting a shortage of beds in nursing homes has increased from 27% in 2014 to 40% in 2018. According to the company, Sweden, Finland and Denmark will need 100,000 new nursing home beds by 2030 in order to face the increasing demand.

3) Outsourcing

The government wants to outsource more and more to private operators. Nordics are behind the rest of Europe in terms of privatization of nursing homes. Indeed, the proportion of nursing homes operated by private operators is below 20% in Norway, Denmark and Sweden. Even Finland, which has the highest proportion amongst Nordics with a penetration rate of 50%, is significantly below the main European markets. As a result, private operators will benefit from the wave of municipalities outsourcing over the coming years.

We believe that municipalities (which fund the majority of social care) will keep outsourcing care and health care to private operators because they operate these activities more efficiently than the public operators. As a result, total costs are lower and services provided are better.

“The price that they (municipalities) are paying us is around 20% lower than the cost of their own operations”

(Source: Q1 2019 Earning conference call)

Besides, the strong economic situation of Nordics will help them to support the increasing burden of an ageing population. Indeed, Nordic countries are amongst the wealthiest and the safest in the world as highlighted by their elevated GDP per capita and their low debt to GDP ratios.

In general, a fragmented market is less attractive because of intensive competition which can be the source of pricing pressure and subdued profitability while a consolidated market is generally much more attractive because of the lack of competition that leads to a higher level of profitability.

The Nordics nursing home industry is very fragmented as highlighted by the 9% market share of the largest player, Attendo. This fragmentation offers consolidation opportunities to largest players. Besides, the supply shortage and the strong demand allow all the players to grow their business; preventing aggressive competition.

Does the stock offer an investment opportunity?

Amongst the three reasons explaining the poor stock performance, we believe that margin pressure is the most important. For that reasons, we are going to explain very quickly why we are not overly concerned about the accelerating labor cost inflation and the potential regulation change in Finland before delving into the margin headwind.

These two issues are somehow related because they both affect compensation costs. Labor cost inflation is the result of a shortage in qualified employees such as nurses. As a result, competition is fierce for attracting and retaining them. However, largest players such as Attendo tend to be more profitable than smaller ones, which give them the possibility to pay higher wages while still remaining more profitable. Moreover, they can also incentive their employees by providing additional training and job rotation. Finally, the contracts with municipalities incorporate specific provisions allowing the company to recoup wage and cost inflation.

“In our contracts with the municipalities in Finland as well as in Scandinavia, we have index losses that enable us to recoup normal wage inflation and cost inflation. And historically, we've been able to do that.”

(Source: Q1 2019 earnings conference call)

In Finland, there was an increasing debate about the conditions of care for older people, which led to several on-site inspections and to higher requirements in terms of staffing density (number of nurse per patient). The company will have to hire more staffs per patient and will not be able to recoup these extra costs. The company estimates that they will spend SEK 200M additional costs in 2019, which represent a negative impact of roughly 180 bps on the EBITA margin (based on our math).

“If we need more stuff due to regulatory reasons, which has happened now, we can't recoup that. We can recoup salary increases and cost inflation generally, but not staff density”

(Source: Q1 2019 earnings conference call)

However, the company should be able to ask for price compensation when the contracts mature. The management has clearly stated that they will not be able to renegotiate a significant part of existing agreements before the start of 2022.

“And then, they move on even though the bulk of the agreements and through the start of 2022. Of course, we have discussions with all the local authorities in Finland in an ongoing basis, to prepare them for price compensation”

(Source: Q1 2019 earnings conference call)

We believe that the fall in operating margin is the most relevant driver of the poor stock performance as highlighted by the following chart.

Despite a higher exposure to the higher margin own operations, margins did not improve.

The main explanation is in the number of bed openings. Indeed, the company has opened a lot of new beds since mid-2017 which has boosted revenue growth. Of course, new beds and new units have lower margins because of related start-up costs and lower occupancy ratio. However, before Q3 2017, the company opened roughly as many beds, as the number of beds that went into mature state; therefore the operating margin was more or less stable. The higher pace of openings after that period did deteriorate the mix between mature and new beds (decreased the group occupancy ratio), resulting in a significant operating margin deterioration.

“We expect an opening pace of around 2,000 this year, and slightly lower next year”

(Source: Q1 2019 earnings conference call)

Margins will unlikely improve before 2021 because the high rate of openings will continue in 2019 and 2020 (even though it would be slightly lower than it used to be in the last few quarters). Besides, a much higher share of bed openings will take place in Scandinavia (mainly Sweden) which is more costly than in Finland. Finally, as discussed previously, the company will initially face higher personal costs in Finland before asking for price compensation.

However, once these new projects have been delivered, the company will grow at a slower pace, allowing margin to recover.

We need to decrease and balance growth pace going forward to secure both quality and profitability

(Source: Q1 2019 earnings conference call)

Indeed, margin of mature units have been stable (between 10% and 11%) over time, confirming that the fall in reported operating margin is the result of the lower-margin new bed openings. Within 18/24 months, new bed openings will become mature; therefore more profitable. With a slower and more balanced growth going forward, the proportion of mature beds will increase, supporting the margin improvement. Besides, the higher exposure to own operations is also positive for margins.

What is the earning power?

We made a quick simulation in order to estimate the earning potential of the existing business. Our scenario assumes that the company will open 2,000 beds in 2019 and 1,900 in 2020 (based on company guidance) and no more beds after that. Considering that new projects reach mature occupancy of 90% within 18 months, we assume that the occupancy ratio (for the total portfolio) will reach 90% by the end of 2022 (24 months after the last opening in 2020). Finally, we estimate a 3% price increase in the Finnish operations in order to take into account the additional costs related to a stricter regulation (The company consider that a 5% price increase is required to fully offset this impact).

Besides, we consider that EBITA margin will reach 12.7% (10% EBITA margin pre-IFRS16 + 270 bps positive impact related to the implementation of IFRS 16) which is still below its highest level of 11.1% in Q1 2017 (pre-IFRS 16 figure). Based on all these assumptions, we obtain an EPS of approximately SEK 5.22.

Valuation

Attendo trades currently at 19x 2019 earnings, which is slightly lower than peers. Assuming that we are correct for our 2022 EPS estimate and that the stock keeps trading at 19x going forward, the stock should climb to SEK 99 by 2022. Assuming a discount rate of 8% in order to derive current valuation, we obtain SEK 78 (44% upside) per share which means that the stock is undervalued (current share price of SEK 54.5). By being more cautious and using a P/E of 15x (historical average close to 18x), the intrinsic value is still 14% above the current price.

NB: Current valuation is the present value (discounted at 8%) of the 2022 valuation.

Conclusion

Attendo did attract our attention given its poor stock performance and the attractiveness of the industry in which the group operates. Our analysis suggests that margins should recover going forward, supported by the transition of new bed openings into a more mature state, which means a higher occupancy ratio as well as a better profitability (no more start-up costs). Besides, the higher exposure to the own operations is also margin supportive. Finally, the company should be able to renegotiate these contracts in order to take into account the additional staffing costs.

Even though we acknowledge that margin recovery level will not happen before 2021/2022, we believe that the stock offers already a decent margin of safety. However, the company could still disappoint in the coming quarters (due to higher costs in Finland), which would create an even more attractive entry point.

Risks:

Political risk: A change in reimbursement rate would affect the company profitability. Historical proposals have already been discussed and rejected by the Swedish parliament.

Reputational risks: Abuse of the elderly is one of the most important risks for a nursing home because it will lead to fines, higher regulatory scrutiny and above all, a lack of trust from municipalities and families.

Wage inflation: Personnel costs account for approximately 65% of sales; therefore a significant increase in wages could jeopardize the company profitability.

Lease inflation: Operating leases and other property costs account for approximately 10% of sales. They are subject to renegotiations, so any adverse moves could jeopardize the group profitability. However, it is important to note that Attendo has negotiation power. Indeed, Attendo is a long-term lessee (so attractive for a lessor) and it can be very difficult for the lessor to re-let its property given the specificities of nursing homes.

M&A: The company could overpay certain assets or/and fail to integrate them properly.

Additional notes:

This table summarizes the different adjustments related to the implementation of IFRS 16.

Disclosure:I/we have no positions in any stocks mentioned, but may initiate a long position in ATTENDO over the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.